The US Economy: The Great Rate Rise and Beyond
National Economic Outlook
Without a doubt, 2022 has not been kind to the U.S. economy – 22Q1 was painful, with GDP declining by an annualized rate of 1.6%, and at this point, the best-case scenario for 22Q2 is for growth of 1%, but growth is more likely to come in slightly negative as the economy has been battered on multiple fronts. While the impacts of Covid-19 are declining, both in the US and globally, supply chain issues remain a problem. Moreover, inflation is very high, and as a result real household incomes have been declining since fall of last year. In addition, household savings, which had been at record highs, is declining as households try to maintain their standard of living by tapping into reserves. This is partly because fuel prices are at record highs, impacting both households and businesses, and the stock market posted the worst half-year since 1970, with both stocks and bonds performing poorly. Lastly, while monthly employment growth remains strong, first-time jobless claims have noticeably risen.
Collectively, this is a lot to overcome, and the forecast for GDP growth for CY2022 is, at best, 1%, with the probability of a recession sometime in 2023 at 75%. The good news, the economy enters this troubling situation in much stronger condition than usual. Corporate balance sheets are strong, household finances are objectively good, and banking institutions are solid. If we do, in fact, wind up in a recession, this is in no way going to be a repeat of the Great Recession of 2008/2009.
Current expectations are that inflation will top out no later than 22Q3, pulled back by both the Federal Reserve Board’s interest rate hikes, organic improvements to supply chains, and slowing consumer demand, especially for goods. That said, the projected decline in inflation is unlikely to be fast enough to change the Fed’s rate-raising trajectory and certainly not after the recent string of strong jobs data. This is because inflation has become increasingly economy wide, and is no longer contained to autos, energy, and food.
As a result, the Fed has made it increasingly clear that they will continue to raise rates due to worsening inflationary pressures, even if it means pushing the economy into a recession. They have signaled intentions to raise the fed funds rate every six weeks for the near future (perhaps for as long as a year) with the next several hikes in the 0.5%-0.75% range and then 0.25% hikes until the inflation target rate is in sight.
If inflation data does not worsen, the Fed will not alter the current course, and 10-year Treasury and 30-year mortgage rates should not increase from where they are now. Of course, if inflation gets significantly worse, the Fed will tighten monetary policy further. Conversely, should inflation dissipate more quickly or should the economy stalls or fall into a recession, the Fed might institute fewer or smaller rate hikes, or stop rate hikes earlier than they would otherwise. Regardless, expectations of inflation went up rapidly in the first half of 2022, and those expectations are baked into the cake, so to speak, and thus rates are more likely, if anything, to fall from where they are now than rise.
National Housing Market Overview
There are several key factors likely to impact the housing market for the foreseeable future. First, while mortgage interest rates are unlikely to get significantly higher than they are now, we are already starting to see the impacts of rising rates on the housing market. May closed sales, based on contracts signed in March and April when interest rates had increased somewhat, already show signs of slowing, and with higher mortgage rates in May and June, sales activity will show additional declines. Analogously, for new residential construction, higher rates are likely to manifest themselves in heightened cancellations of sales contracts which are already being seen. In addition to interest rate impacts, expectations of some softening in the job market, reduced household savings, and falling equity prices will also slow sales. We already see this in data for weekly applications for first-time mortgages, which continue to decline on a relative basis compared to pre-pandemic levels.
Another meaningful change of late in the housing market is the rise in year-over-year inventories for the first time since early 2019. That said, while inventory growth is high in percentage terms, the actual number of units available for sale remains relatively small. At the national level, available inventories are at 1.16 million units, well below normal pre-pandemic levels. Price appreciation through the first half of the year was surprisingly strong, much stronger than most economists had predicted. However, higher home prices and interest rates will manifest in slowing rates of home price appreciation, which should go from the 15-20% range over the past year to closer to 5-7% by year end. If inflation is considered, real price appreciation may well be close to zero.
In terms of new housing supply, new construction of multifamily properties will continue to do well but perhaps soften slightly because of tightening credit conditions. That said, very low and declining vacancy rates, strong Gen Z household formation, and many would-be first-time buyers who have been priced out of the entry-level housing market should keep new rental construction from much of a decline. Single-family starts are also likely to decline little from where they are now. That is because despite profound buyer demand, new home construction activity since mid-2020 has been held back by a steady lack of workers, supplies, and land. As a result, home builders were never able to ramp up production to meet the large rise in Covid-19 induced demand. Instead, homebuilders find themselves in the unenviable position of having more single-family units currently under construction than ever before, not due to surging starts but rather due to an ongoing inability to complete homes already under construction due to myriad supply problems. Importantly, the shortage of workers is likely to persist for the foreseeable future especially as federal and state agencies start to roll out projects funded under the Infrastructure Investment and Jobs Act of 2021.
In short, demand for housing remains strong, and demographics remain favorable. Further, even as individual buyers get priced out, Wall Street continues to buy houses to rent, which puts a floor under price appreciation. Thus, even if there is a recession, there will be fewer impacts to the housing market because we have never been this undersupplied entering an economic downturn, nor have so many homeowners had so much home equity. The bottom line, this housing market is still a seller’s market, but less so than it has been for the past few years.
National Non-Residential Market Overview
Turning our attention to the commercial construction sector, hotel construction appears to have bottomed and should steadily recover as pent-up demand for travel and leisure pursuits makes itself felt, and there is a return to normality. As for restaurants and retail in general, so long as they are not located in the central business district, and thus dependent on commuters for the bulk of their business, construction activity should slowly improve over time.
Manufacturing facilities, warehouses, and data centers have been a bright spot from the start of the pandemic and show no signs of letting up. And of late, cold-storage facilities can be added to the list of underbuilt properties as food delivery becomes increasingly popular. Lastly, institutional building such as schools, universities and religious institutions are likely to struggle as Covid-19 continues to reduce the desire for large indoor gatherings.
Finally, office space construction is likely to transition from downtown to outlying areas for several reasons. First, B and C quality office space is likely to remain a severe liability for employers who wish to lure their employees back to the office. Second, due to the increasingly prevalent work-from-home phenomenon, office towers in downtown locations are now less desirable than in the recent past. As a result, new office space located in suburbia, yet also within walking distance to stores, restaurants, entertainment, and housing will be increasingly prized yet as of today is in short supply.
In summary, a recession sometime in 2023 is increasingly likely due to the combination of weak GDP growth and overly restrictive monetary policy. That said, and while much can still go wrong, the expected recession is likely to be mild, last 8-12 months, and see GDP decline by not more than 1.5%. Inflation, while a large concern at present, will likely slowly fade away over the next several years. Lastly, residential construction will, at most, modestly decline, but not more as demand is high, and undersupply has been chronic for over a decade. As for non-residential construction, some segments will outperform others, so positioning will be key.